Proactively taking cues from the shifting dynamics, the Indian IT companies once again exhibited the strength of their business model. While operating under challenging circumstances, they managed to improve their margins and free cash flow (DSO improvement) despite extending pricing discounts and credit lines to select few clients whose business models were completely disrupted. Almost all the companies witnessed strong deal wins while their order books remained at an all-time high. Moving forward, a low-cost offshore delivery center would further help the IT companies’ clients to reduce the total cost of ownership of IT.
The IT sector reported a healthy recovery in Q1FY22, aided mainly by a ramp-up on the deal wins in the previous quarters. Deal wins also remained high and we expect healthy growth momentum to continue in Q2FY22 as well as in the rest of the FY22 led by 1) Improvement in supply-side challenges, 2) Strong exit rate and 3) Healthy demand with deal wins during the quarter. We expect the Indian IT companies to grow at 13%-15% in FY22E and in FY23E.
Despite a healthy recovery in deal wins, the Indian IT companies posted weaker Operating Margins in Q1FY22 owing to the macroeconomic challenges, higher employee costs, and weaker currency fluctuations. On a positive note, the Indian IT services companies successfully adopted a new business model and seamlessly transformed to work-from-home (WFH) without negatively impacting their deliverables. We expect the margins to improve gradually hereon as revenue recovers though there may be a few headwinds such as impacted travel, and higher marketing costs, among others which may dampen this recovery. The Indian IT companies are gravitating towards a sustainable WFH delivery and extreme off-shoring model which are likely to be margin accretive. We expect the IT companies to deliver EBIT Margins of 21%-22% in FY22E.
North America region is one of the major geographies contributing around 60% of the top line of most of the Indian IT services companies, witnessed momentum gaining in its IT spending. The demand scenario continues to remain resilient despite challenging macroeconomic conditions. While the US elections may marginally impact allocation towards IT spends in the near term, we remain cautiously optimistic on the US business from a medium to long-term perspective.
In terms of IT spends,
Europe is the second-largest geography after North America and contributes around 30% of the total revenues of the Indian IT services companies. It exhibited a positive movement and we expect encouraging traction in the European Banking business going forward as well as healthy recovery in the verticals such as travel, manufacturing, and retail.
Segment-wise, the BFSI contributes significantly to the Indian IT sector and we expect it to recover faster vis-à-vis other verticals. Managements of leading Indian IT companies expect BFSI to continue showcasing resilience in light of the revival of demand in cloudification, other digital services, capital markets as well as European banking.
Cancellation of major sporting and entertainment events adversely impacted advertising spends in the media sub-vertical, which in turn, significantly impacted the overall performance of the communications & media vertical. We believe there will be a gradual pickup in the demand for 5G networks in the forthcoming quarters as economies scale back to pre-Covid levels.
The retail vertical got significantly impacted due to the Covid pandemic and the consequent global lockdown. It was impacted by the virtual shutdown of many retail segments as well as severely hampered activity in the travel sub-vertical. However, a few sub-segments such as grocery, pharmacy, retail, and CPG performed well during the quarter.
We believe the IT services sector will deliver sustained growth, aided by robust demand for services such as cloud computing, IoT, business analytics, and other digital business and will gain further momentum in the long term.
(The author, Omkar Tanksale, is a Senior Research Analyst – IT, Axis Securities. The views are his own.)
